China & EM Asia
Highlights So What? The late-cycle rally still faces non-trivial political hurdles. Why? U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit continue to pose risks. A shocking revelation from the Mueller report could have a temporary negative impact on equity markets. A bombshell would increase Trump’s chances of removal from office. We give 35% odds to tarrifs on autos and auto parts, and 10% odds to a hard Brexit. Feature In our February 6 report we outlined how a “Witches’ Brew” of geopolitical risks had the potential to short-circuit the late-cycle equity rally. A month later, that brew is still bubbling. President Donald Trump’s approval rating has rebounded but going forward it faces challenges from negative headlines (Chart 1). These include a soaring trade deficit, a large influx of illegal immigrants on the southern border, a weak jobs report for February, a setback in North Korean diplomacy, and an intensification of the scandals plaguing Trump’s inner circle. Chart 1Don't Get Comfortable Just Yet, Mr. President Each of these issues calls into question the effectiveness of Trump’s core policies and the stability of his administration, though in reality they are only potentially problematic. While Special Counsel Robert Mueller’s forthcoming report poses a tail risk, the substantial threat remains Trump’s trade policy. Indeed, investors face “the persistence of uncertainties related to geopolitical factors” and the “threat of protectionism,” according to European Central Bank President Mario Draghi, who spoke as he rolled out a new round of monetary stimulus for Europe and its ailing banks. What did Draghi have in mind? The obvious culprits are the U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit. There were other issues – such as “vulnerabilities in emerging markets” – but the first three are the most likely to have turned Draghi’s head. The global economic outlook is likely to improve on the back of Chinese stimulus and policy adjustments by the ECB and Federal Reserve. But growth has not yet stabilized and financial markets face additional volatility due to the fact that none of these “geopolitical factors” is going to be resolved easily. The good news is that Trump, overseeing a precarious economy ahead of an election, has an incentive to play softball rather than hardball. Mueller’s Smoking Gun? News reports suggest that Mueller will soon issue the final report of his investigation into President Trump’s election campaign links with Russia. There is really only one way in which the Mueller report could be market relevant: it could produce smoking-gun evidence that results in non-trivial impeachment proceedings. Any scandal big enough to remove Trump from office or clearly damage his reelection chances is significant because financial markets would dislike the extreme policy discontinuity (Chart 2). Anything short of this will be a red herring for markets, though admittedly many of our clients disagree. Very little is known about what Mueller will report and how he will interpret his mandate. Mueller’s investigation may or may not make it to the public in full form, at least initially, and he may or may not make any major additional indictments. Congress will strive to get access to the report, which is internal to the Justice Department, while spin-off investigations will proliferate among lower-level federal district attorneys and congressional committees. The legal battle, writ large, will run into the 2020 election and beyond. House Democrats alone can decide whether to bring articles of impeachment against Trump, but the case would be struck down in the Senate if it did not rest on ironclad evidence of wrongdoing that implicated Trump personally. Republican Senators will not jump ship easily – especially not 18 of them. That would require a sea change in grassroots support for Trump. Trump’s approval among Republicans remains the indicator to watch, and it is still strong (Chart 3). If this number crashes in the aftermath of the Mueller report, then Trump could find himself on a Nixonian trajectory, implying higher odds of a Senate conviction (Chart 4). At that point, markets would begin discounting a Democratic sweep in 2020, with business sentiment and risk assets likely to drop at the prospect of higher taxes and increased regulation (Chart 5). Chart 5A 2020 Democratic Sweep Would Dent Business Sentiment After all, if scandals remove Trump from office, then not only is a Democrat likely to win the White House, but any Democrat is likely to win – even a non-centrist like Bernie Sanders or other Democratic candidates like Kamala Harris who have swung hard to the left. Meanwhile, the odds of Democrats taking control of the Senate (while keeping the House) will rise. With Democratic candidates flirting with democratic socialism and proposing a range of left-wing policies, the prospect of full Democratic control of the legislative and executive branches would weigh on financial markets. We doubt that the Mueller report can fall short of a smoking gun while still dealing a fatal blow to Trump. The Democrats control the House, so if the scandal grows to gigantic proportions, they will impeach. Yet if they impeach without an ironclad case, Trump will be acquitted. And if Trump is acquitted, it is hard to see how his chances of reelection would fall. The impeachment of former President Bill Clinton looms large over Democrats, since it ended up boosting his popularity. If Democrats are overzealous to no end, it will help Trump’s campaign. If Trump should then win re-election, he will have veto power and likely a GOP Senate, so his policies will remain in place. The outcome for markets would be policy continuity, though the market-positive aspects of Trump’s first term may not be improved while the market-negative aspects, such as his trade policy and foreign policy, may reboot. Mueller is an all-or-nothing prospect: he either leads us to the equivalent of the Watergate Tapes or not. Lesser crimes are unlikely to have a decisive impact on the election. But volatility is likely to go up as the report comes due, just as it did during the Lewinsky scandal (Chart 6), at least until the dust settles and there is clarity on impeachment. And an equity sell-off at dramatic points in the saga cannot be ruled out, especially if global factors combine with actual impeachment (Chart 7). Chart 6Impeachment Proceedings Likely To Raise Vol... Chart 7… And Potentially Dampen Returns Bottom Line: A specific, shocking revelation from the Mueller report could have a negative impact on equity markets and risk assets, but any such moves would be temporary as long as the growth and earnings backdrop remain positive and Mueller does not drop a bombshell that increases Trump’s chances of removal from office. Separating The Budget From The Border The president faces adverse developments on the southern border after having initiated a controversial national emergency in order to transfer military funds to construct new barriers. The U.S. has seen an abnormally large increase in apprehensions and attempted entries this year (Charts 8A & 8B). Ultimately the influx calls attention to the porous southern border and as such may help to justify Trump’s policy focus. For now it raises the question of why the administration’s tough tactics are failing to deter immigrants. Meanwhile his emergency declaration has divided the Republican Party, with several members likely to join with Democrats in a resolution of disapproval that Trump will veto. Congress will not be able to override the veto, but Trump’s decree also faces challenges in the judicial system. We doubt that the Supreme Court will rule against him but it certainly is possible. The ruling is highly likely to come before the election. Meanwhile Trump is kicking off the FY2020 budget battle with his newest request of $8.6 billion for the border wall and cuts to a range of discretionary non-defense spending. The presidential budget is a fiction – it is based on unrealistic cuts to a range of government programs. Any budget that is passed will bear no relation to the administration’s proposals. Opinion polls referenced above clearly demonstrate that Trump’s approval rating suffered from the recent government shutdown. This does not mean that he will conclude the next budget battle by the initial deadline of October 1 or that a late-2019 shutdown is impossible. He might accept a short shutdown to try to secure defense spending that would arguably legitimize his repurposing of military funds for border construction. But his experience early this year means that the odds of another long-running, bruising shutdown are low. Might Trump refuse to raise the debt ceiling later this year to get his way on the wall? This is even less likely than a shutdown due to the negative impact that a debt ceiling constraint would have on social security recipients and bond markets. Trump also has the most to lose if the 2011 budget caps snap back into place in 2020 due to any failure of the FY2020 negotiations (Chart 9). As such, the debt ceiling – which the Treasury Department can keep at bay until the end of the fiscal year in October – and the 2020 budget may be resolved together this time around. In short, Trump will be forced to punt on congressional funding for the wall later this year and will have to campaign on it again in November 2020, with the slogan “Finish the Wall.” This is a market-positive outcome, as the hurdles to fiscal spending in 2020 are likely to be reduced: Trump will have to concede to some Democratic priorities and abandon his proposed cuts. The Democrats, for their part, are likely to have enough moderates to get the next budget over the line with Republican support. To illustrate, Republicans only need 21 votes for a majority, while no fewer than 26 Democrats were recently chastised by House Speaker Nancy Pelosi for cooperating with Republicans. The implication is that a bipartisan majority can be found. Since Trump cannot get his budget cuts, and does not really even want them, the projected contraction of the budget deficit in 2020 will be reduced or erased (Chart 10). On the margin, this would support higher inflation and bond yields. The biggest threat to Trump’s reelection is still the risk that the long business cycle will expire by November next year. However, the exceedingly low February payrolls print was misleading – the unemployment rate fell and wage growth was firm (Chart 11). American households are in relatively good shape and that bodes well for Trump, for the time being. Chart 11American Households Are In Good Shape Bottom Line: The economy is relatively well supported and Trump and the Democrats are ultimately likely to cooperate on the budget under the table, reducing the risks of a debt ceiling breach, or an extended government shutdown later this year, or a fall off the 2020 stimulus cliff. The Trade Deficit: Trump’s Pivot To Europe Trade policy is where Trump’s challenges merge with Draghi’s woes. The U.S. trade deficit lurched upwards to a ten-year high of $621 billion in 2018 (Chart 12). The trade deficit is uniquely important to Trump because he campaigned on an unorthodox protectionist agenda in order to reduce it. It will be very difficult for him to evade the consequences if the deficit is higher, as a share of GDP, in November 2020 than it was in January 2017. Chart 12Trade Deficit Jump Is A Blow To Trump The underlying cause of the rising deficit is that a growing American economy at full employment with a relatively strong dollar will suck in larger quantities of imports. This effect is overriding any that Trump’s tariffs have had in discouraging imports. Meanwhile the global slowdown, reinforced by trade retaliation and negative sentiment, are harming U.S. exports (Chart 13). The administration’s policies of fiscal stimulus combined with encouraging private investment are guaranteed to lead to a higher current account deficit, barring an offsetting (and highly unlikely) rise in private saving. The current account deficit must equal the gap between domestic saving and investment and a rising fiscal deficit represents a drop in saving. Chart 13Trade War Hurting U.S. Exports What does the trade deficit imply for the U.S.-China talks? On one hand, the U.S. could put more pressure on China after feeling political heat from the large deficit. On the other hand, China has always offered to reduce the bilateral trade deficit directly through bulk purchases of goods, particularly commodities. It is Trump’s top negotiator, Robert Lighthizer, who has insisted that China make structural changes to reduce trade imbalances on a long-term and sustainable basis.1 In a sign of progress, the U.S. and China have reportedly arrived at a currency agreement. No details are known and therefore it is impossible to say if it would mean a more “market-oriented” renminbi, which could fluctuate and have a variable impact on the trade deficit, or a renminbi that is managed to be stronger against the dollar, which would tend to weigh on the deficit, as Trump might wish. The two negotiating teams are working on the text of five other structural issues that should also mitigate the deficit. Moreover, China’s new foreign investment law, if enforced, could increase American market access by leveling the playing field for foreign firms. However, there is still no monitoring mechanism, the two presidents have not scheduled a final signing summit, and the deterioration in North Korean peace talks also works against any quick conclusion. If Trump concludes a deal, the next question for investors is whether he will impose Section 232 tariffs on auto and auto imports on the EU and other partners (Chart 14). The European Commission’s top trade negotiator, Cecilia Malmstrom, recently met with Lighthizer in Washington to discourage tariffs. She refused to admit agriculture into the negotiations, as per a U.S.-EU joint statement in July 2018, but proposed equalizing tariffs on industrial goods as a way for both sides to make a positive start (Chart 15). She said that the U.S. repealing the Section 232 steel and aluminum tariffs are necessary for any final deal. And she reiterated that any new tariffs (e.g., the proposed Section 232 tariffs on autos and auto parts) would prevent a deal and provoke immediate retaliation on $23 billion worth of American exports. Malmstrom also said that the EU would prefer to work with the U.S. on reforming the World Trade Organization and addressing China’s trade violations. This approach fits with that of Japan, which has joined the U.S. and EU in trilateral discussions toward reforming the global trade architecture in a bid to mitigate U.S. protectionism and constrain China. The problem with the EU’s position is that once the U.S. and China make a trade deal, the U.S. will not have as immediate of a need to form a trade coalition against China (other than in dealing with WTO issues). Moreover, Japan will be forced to accept a deal with the U.S. in short order. A rotation of Trump trade policy to focus on Europe is likely. We give 35% odds to tariffs on autos and auto parts. The USMCA will increase the cost of production in North America while Europe is so far excluding cars from negotiations with the U.S., so there is room for a clash. But any tariffs on autos will be less sweeping than those against China. Trump will play softball rather than hardball for the following reasons: The public is less skeptical of trade with Europe and Japan than with China. The auto sector is heavily concentrated in the Red States and many states that are heavily exposed to trade with the EU are also critical to Trump’s reelection (Map 1). Section 232 tariffs that are required to be enacted by May 18 would have plenty of time to impact the U.S. economy negatively by November 2020. Congress and the defense establishment are against a trade war with U.S. allies, while bipartisanship reigns when it comes to tougher actions toward China. The bilateral trade deficit is less excessive with Europe than with China (see Chart 12 above). The U.S. carmaker and auto parts lobby are unanimously against the tariffs – and in fact has called for the removal of the steel and aluminum tariffs in a stance that echoes that of the EU. The existing steel and aluminum tariffs provide Trump with leverage in the negotiations with the EU and Japan, whereas the U.S. has agreed not to impose new tariffs on these partners while trade negotiations are underway. New tariffs would nix negotiations and ensure that the ensuing quarrels are long and drawn out, with a necessarily worse economic impact. To initiate a new trade war in the wake of the U.S.-China war would be to undercut the positive impact on trade, financial conditions, and sentiment that is supposedly driving Trump’s desire for a China deal in the first place. The U.S. eventually will need to build a trilateral coalition to hold China to account and ensure that it does not slide back into its past mercantilist practices. Even limited or pinprick tariffs will have an adverse impact on equity markets, given that they will hit Europe at a time when its economy is decelerating dangerously and when Brexit uncertainty is already weighing on European assets and sentiment (see next section). This may be why both the U.K. and Germany have recently softened their positions on Chinese telecom company Huawei, which they have been investigating for national security concerns related to the rollout of 5G networks. They are signaling that they are not going to sacrifice their relationship with China if the U.S. is dealing with China bilaterally while threatening to turn around and slap tariffs on their auto exports. If the U.S. goes ahead with tariffs – on the basis that its China agreement allows it to isolate Europe – the EU will not be a pushover, as exports to the U.S. only amount to 2.6% of GDP (Chart 16). The result of the U.S.-China quarrel has been a deepening EU-China trade relationship and that trend is set to continue (Chart 17), especially if the U.S. continues to use punitive measures that increase the substitution effect and the strategic value of the Chinese and European markets to each other. Chart 16The EU Will Not Be A Pushover In Face Of U.S. Tariffs Chart 17EU-China Trade Relationship Deepening Bottom Line: In the wake of any U.S.-China agreement, we give a 35% chance that Trump will impose tariffs on European cars and car parts. Such tariffs are not our base case because they are unlikely to shrink the U.S. trade deficit and would have a negative impact on the Red State economy. But lower magnitude tariffs cannot be ruled out – and the impact on the euro and European industrial sector would clearly be detrimental in the short run. Assuming that global and European growth is recovering, a tariff shock to Europe’s carmakers could present a good opportunity to buy on the dip. Any U.S.-EU trade war will ultimately be shorter-lived and less disruptive than the U.S.-China trade war, which is likely to resume at some point even if Presidents Trump and Xi get a deal this year. The United Kingdom: Snap Election More Likely A series of important votes is taking place in Westminster this week, with the end result likely to be an extension to negotiations over a withdrawal deal at the EU Council summit on March 21. Conditional on that extension, the odds of a new election are sharply rising. The first vote, as we go to press on Tuesday, has resulted in a rejection of Prime Minister Theresa May’s exit plan by 149 votes – the second rejection after her colossal defeat in January by 230 votes. The loss was expected because the EU has not offered a substantial compromise on the contentious Irish “backstop” arrangement, which would keep Northern Ireland and/or the U.K. in the European Customs Union beyond the transition date of December 31, 2020. All that was offered was an exit clause for the U.K. sans Northern Ireland. But Northern Ireland is part of the U.K. and the introduction of additional border checks on the Irish Sea would mark a new division within the constitutional fabric. This is unacceptable to the Conservative Party and especially to the Democratic Union Party of Northern Ireland, which gives May her majority in parliament. On Wednesday, we expect the vote for a “no deal” exit, in which the U.K. simply leaves the EU without any arrangements as to the withdrawal (or future relationship), to fail by an even larger margin than May’s plan. Leaving without a deal would cause a negative economic shock due to the automatic reversion to relatively high WTO tariff levels with the EU, which receives 46% of the U.K.’s exports and is thus vital in the maintenance of its trade balance and terms of trade (Chart 18). It is impossible to see parliament voting in favor of such an outcome – parliament was never the driving force behind Brexit, with most MPs preferring to remain in the EU. Chart 18No Deal Brexit A Huge Blow To U.K. The risk is that parliament should fail repeatedly to pass the third vote this week, a motion asking the EU for an extension period to the March 29 “exit day.” This is unlikely but possible. In this case, the supreme decision-making body of the U.K. will be paralyzed. A bloodbath will ensue in which the country will either see Prime Minister May ousted, a snap election called, or both. If the extension passes, the EU Council is likely to go along with the decision. It is in the EU’s near-term economic interest not to trigger a crash Brexit and in its long-term interest to delay Brexit until the U.K. public decides they would rather stay after all. The problem is that it will not want to grant an extension for longer than July, when new Members of the European Parliament take their seats after the May 23-26 EU elections. The U.K. may be forced to put up candidates for the election. What good would an extension do anyway? The likeliest possibility is, yet again, a new election. The conditions are not yet ripe for a second referendum, though the odds are rising that one will eventually occur. The Labour Party has fallen in the opinion polls amidst Jeremy Corbyn’s indecisive leadership and a divisive platform change within the party to push for a second Brexit referendum (Chart 19). An election now gives May’s Conservatives an opportunity to build a larger and stronger majority – after all, in the U.K. electoral system, the winner takes all in each constituency, so the Tories would pick up most of the seats that Labour loses. May’s faction might be able to strengthen its hand vis-à-vis hard Brexiters who have less popular support yet currently have the numbers to block May’s withdrawal plan. Chart 19A New Election Would Be Opportunistic Theresa May might be unwilling to call an election given her fateful mistake of calling the snap election of 2017. If she demurs, she could face an internal party coup. There is a slim chance that a hard Brexiter could take the helm, bent on steering the U.K. out of the EU without a deal. Parliament, however, would rebel against such a leader. Ultimately, the economic and financial constraints of a crash Brexit are too hard and we expect that the votes will reflect this fact, whether in an adjusted exit deal or a new election. But both outcomes require an extension. However, we must point out that the constitutional and geopolitical constraints alone are not sufficient to prevent a crash out: parliament is the supreme lawmaking authority and there is no other basis for the U.K. to leave in an orderly fashion. The United Kingdom has survived worse, as many hard Brexiters will emphasize. A crash is a mistake that can happen. But the odds are not higher than 10%-20% given the stakes (Diagram 1). Diagram 1The Path To Salvation Remains Fraught With Dangers With the EU economy not having stabilized and the U.S. contemplating Section 232 trade tariffs, Brexit is all the more reason to be wary of sterling, the euro, and European equities in the near term, especially relative to the U.S. dollar and U.S. equities. Gilts can rally even in the event of an extension given the uncertainty that this would entail, though the BCA House View is neutral. Bottom Line: Expect parliament to ask for an extension. At the same time, the odds of a new election have risen sharply. The absence of a new election could lead to a power struggle within the Tory party that could escalate the risk of a hard Brexit, though we still place the odds at 10%. A second referendum is rising in probability but will only become possible after the dust settles from the current crisis. Investment Conclusions The ECB’s stimulus measures are positive for European and global growth over a 6-to-12-month time frame. They suggest that financial assets could be supported later in the year, depending in great part on what happens in China. China’s combined January and February total social financing growth reinforces our Feb 20 report arguing that the risk of stimulus is now to the upside. As People’s Bank Governor Yi Gang put it, the slowdown in total social financing last year has stopped. The annual meeting of the National People’s Congress also resulted in largely accommodative measures on top of this credit increase. Nevertheless, stimulus operates with a lag, and for the reasons outlined above we are not yet willing to favor EUR/USD or European equities within developed markets. A 35% chance of tariffs is non-negligible. We expect U.S. equities to outperform within the developed world and Chinese equities to outperform within the emerging world on a 6-to-12 month basis. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1 Lighthizer now has bipartisan support in Congress, whose members will lambast Trump if he squanders the historic leverage he has built up in exchange for a shallow deal that only temporarily weighs on the trade deficit.
Highlights So What? The late-cycle rally faces non-trivial political hurdles. Why? The rally is based on a too-sanguine view of the Fed, China, and the trade war. Other issues – like Brexit and the U.S. border showdown – are also problematic. Venezuela still has the potential to push oil prices sharply upwards. Feature All is well. Global equities are on the path of recovery, as should be the case at the end of an economic cycle. The U.S. S&P 500 has gained 16% since the bottom on December 24, with healthy technicals suggesting a breakout is ahead (Chart 1). The S&P 500 may be entering one of its typical late-cycle rallies, which tend to be the second best-performing decile of a bull market (Chart 2).1 Meanwhile, emerging market equities and currencies are outperforming developed market peers (Chart 3), a reversal from 2018 Chart 1Late Cycle Rally Ahead? Chart 3...As Does Current Global Outperformance Typically, global risk assets outperform American risk assets at the end of an economic cycle. While institutional investors can use these rallies to lighten the load ahead of a recession, most investors cannot afford to miss such a rally. As such, BCA (and others) are calling for investors to play what is expected to be a yearlong rally in global risk assets and the S&P 500. Our view at BCA Geopolitical Strategy is more cautious, perhaps because it is informed by a methodological bias rooted in geopolitics. We believe that the reversal in U.S. outperformance relative to global risk assets rests on three pillars: The Federal Reserve remains dovish throughout 2019; China begins a major reflationary effort; The U.S.-China tariff truce results in a trade deal. In addition, a consensus is emerging that a “no deal” Brexit will not occur, that U.S. polarization cannot get worse, and that President Trump eschews foreign interventionism. While we hold a nuanced view on each of these assertions, the mix is far less bullish than investors may think. We see a witches’ brew of factors that is murky at best and bearish at worst. The Three Pillars Of The Bullish View Before we turn to geopolitics, let us examine the three pillars underpinning the bullish view. Our colleague Peter Berezin, BCA’s Chief Global Strategist, remains bullish on the U.S. economy and expects the Fed to resume hiking rates by mid-year.2 The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 4). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 5). Chart 4Little Sign Of A Looming Credit Crunch Chart 5Capex Plans Still Solid It is no surprise that the BCA Fed Monitor continues to suggest that “tighter monetary policy is required” (Chart 6). This is a far cry from 2016, when our indicator was in deeply “tightening” territory and the Fed paused for 12 months. If we compare 2019 to 2016, it is difficult to see how the market expectation of 4.72 bps of rate cuts will occur over the next 12 months (Chart 7). Of the three components that make up the BCA Fed Monitor, only the financial conditions have fallen into “easing required” territory (Chart 8), and they are already shifting back to “tightening required” territory with the stock market rally underway (Chart 9). Chart 6A Hawkish Fed Is Needed Chart 8BCA Fed Monitor Calls For Tighter Policy Chart 9Financial Conditions Starting To Ease In addition, in 2016 the Fed was not contracting its balance sheet. Today it is doing so, although the pace has moderated. As such, the Fed’s rate hike pause is occurring amidst an ongoing effort to normalize monetary policy and to transfer rate risks back to the private sector. By chance, this is also occurring at a time when the Treasury Department must issue more debt to cover a larger deficit, a process that could significantly pull U.S. rates higher and, by extension, yields on assets further down the risk curve. This would be a particular problem for global risk assets given the exposure of several EM economies to dollar-denominated debt. The bottom line for investors is that a rate hike pause is not a pause in the overall hawkish policy of the U.S. Fed, which acts as a global central bank. The fall in the amount of dollars available for the international financial system acts as a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, BCA’s Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart 10). Chart 10Deteriorating Excess Liquidity Hurts Global Growth Our muted view on Chinese reflation is unnecessary to repeat here. There is no doubt that Chinese policymakers are stimulating the economy, but the question is whether they are willing to pull the credit lever as aggressively as they have done in the past (Chart 11).So far, all of the evidence we have reviewed point to a cautious effort to stabilize growth, not reflate the entire planetary economy as Beijing did in 2016. If our BCA House View on the Fed is correct, a tepid Chinese effort to stimulate the domestic economy will fall short of lighting the flame of a global risk rally in 2019. Chart 11Compare Any Stimulus To Previous Efforts The BCA China Play Index, which in the past has tracked EM vs. DM equity outperformance, is sending mixed signals today (Chart 12). Enthusiasm for global risk assets has not been confirmed by the most China-sensitive plays. Chart 12Mixed Signals From China-Sensitive Plays Finally, there is the trade truce that should produce a trade deal. The logic is clear: President Trump sets aside the political constraints working against a deal and focuses on ensuring that he wins 2020 by avoiding a recession. The near bear market in the S&P 500 was a game changer that focused the White House on averting any further downside to markets and the economy from the trade war. But if the current rally proves that the selloff in December was a temporary pullback, the White House may be emboldened to play hard-to-get with China. After all, the electorate is generally supportive of getting tough on China (Chart 13) and there is no demand from either Trump voters or Democrats for a quick deal. The Fed pause and lower oil prices also give Trump some space to push negotiations a bit harder. Already there are leaks from the negotiations that the U.S. is asking for a lot from China, which could prolong the talks. This includes genuine structural changes to the economic relationship that would address long-standing U.S. concerns of forced technology transfers, intellectual property theft, and foreign investor access to the Chinese domestic market. It also includes U.S. demands that these changes be verifiable and enforceable. China is likely to balk at some of the U.S. demands, particularly if the U.S. is indeed pushing for regular reviews of China’s progress, a condition that implicitly creates a hierarchy between the two economies and would thus represent a loss of face for Beijing.3 Table 1 presents our latest expectations of where the U.S. and China will be on March 1. We assign only 10% each to “black and white” outcomes, a “Grand Compromise” and “No deal, with major escalation.” The remaining 80% is divided between “mushy” outcomes, including a 25% probability that negotiations simply continue. Table 1Updated U.S.-China Trade War Probabilities How would the market react to such uncertain outcomes? We think that almost anything other than a “Grand Compromise” would be greeted with limited relief, if not outright market correction. A vaguely positive meeting between Presidents Trump and Xi, and a memorandum of understanding, would not remove long-term risks in the relationship, especially if the parallel “tech war” is not resolved. On top of the ongoing U.S.-China negotiations, there is one remaining trade issue that investors should keep in mind: auto tariffs. The Section 232 investigation into whether auto imports are a national security threat is ongoing and U.S. authorities are expected to present their conclusions on February 17. We fear that the Trump administration could still stage a surprise and impose tariffs on auto imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production within the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. An extended truce with China could provide the opportunity. The Trump administration may not have the stomach for a long-term trade war with Europe, but the timing of this decision could upset the market’s perception of Trump’s commitment to free trade once again. Bottom Line: The conventional narrative is that global markets are experiencing a late-cycle rally, one that is worth playing given its usual duration and amplitude. This view rests on three pillars: that the Fed has backed off from tightening, that China is stimulating in earnest, and that the trade deal will produce a definitive outcome. We fear that all three pillars are shaky. First, the Fed is not easing. Its balance sheet contraction process, which is ongoing, is a form of tightening. And the U.S. economy remains healthy. As such, the expectation of a 12-month Fed pause is overly optimistic. Second, China is stimulating, but only tepidly. Third, “black and white,” definitive outcomes are unlikely in the U.S.-China negotiations. In fact, more protectionism could be around the corner if U.S.-China tech issues continue to flare or if the U.S. announces the conclusion of its investigation into auto imports. Geopolitical Factors To Monitor Aside from shaky pillars, markets will also have to contend with several uncertain geopolitical processes this year. While we are not necessarily bearish on each one, we are concerned that the collective investment community is overly bullish. Take Brexit. We agree with the conventional view that the chances of a no-deal Brexit outcome are below 10%. Political betting markets have only priced in an actual exit on March 29, which is in ink in British legislation, at just above 30% (Chart 14). Chart 14Online Betters Expect A Brexit Delay The problem is not with the conventional view but with its timing. While Prime Minister Theresa May will ultimately be forced to extend the Article 50 deadline, it may take a lot of brinkmanship and eleventh hour negotiations to do so. Getting from here – collective bullishness – to there – an actual extension of Article 50 – may require a downturn in GBP/USD or other U.K. assets. Furthermore, several scenarios could produce a downturn in GBP/USD (Diagram 1). For example, the Labour Party remains neck-and-neck with the Tories in the polls, despite being led by the most left-leaning leader since the 1970s. Although a new election that produces a Labour government would likely reduce the odds of Brexit eventually occurring, it would raise the odds of Corbyn pursuing unorthodox economic policy while also trying to negotiate his own version of Brexit with the EU. Diagram 1Brexit: The Path To Salvation Remains Fraught With Dangers The point is that it is tough to recommend that investors close their eyes and buy GBP/USD, no matter how cheap the currency may look, unless one has a very long time horizon and a high threshold for pain. The second issue where we take a more nuanced position is the ongoing U.S. executive-legislative standoff over the border. The government shutdown is only on pause until February 15. The House Democrats are demanding that a solution be found by Friday, February 8 if it is to be voted on in time. Meanwhile President Trump’s popularity is in the doldrums (Chart 15). His supporters note that President Reagan was even less popular at this point in his term, but that is because unemployment hit 10.4% in January 1983 (Chart 16). The grave risk for President Trump is that he is as unpopular as Reagan, even though unemployment is at 4% and the U.S. economy is on fire. Chart 15President Trump Is Unpopular... Chart 16...And It Can't Be Blamed On Unemployment As such, the real risk is not another shutdown, but rather political dysfunction in Congress that imperils the legislative process. The current two-year budget deal, which raised spending levels in January 2018, is set to expire when the FY2019 ends. Democrats and Trump have to come to an agreement to avert the “stimulus cliff” expected in 2020 (Chart 17). If they cannot conclude the border issue and the FY2019 appropriations, then Trump may declare a national emergency (or act unilaterally in other ways) and spark a new conflict with the courts. He could also threaten not to raise the debt ceiling in spring or summer. This is not an atmosphere in which a FY2020 deal looks very easy. Chart 17Stimulus Cliff Ahead Ultimately, we expect Democrats to succumb to the pressure from their voters for more spending. But a total failure to cooperate is a risk. Furthermore, the greatest political risk in the U.S. is that the 2020 election will not be contested on the same issues as in 2016: trade and immigration. Instead, income inequality is rearing its head, as Democratic candidates jostle for attention and as they test various messages on focus groups. If income inequality catches fire as the issue of 2020, we will know it soon. And it may begin to impact the markets as Democrats begin to campaign on, for instance, reversing President Trump’s income tax cuts. While the market may ignore headline election risks for some time, we do not think that non-financial corporates can do the same. Any hint that President Trump’s pro-business policies will be reversed could send shivers down the spines of CEOs and negatively impact capex intentions, hurting the real economy well before the next election. Finally, there is the issue of foreign policy. President Trump has abandoned his maximum pressure tactic on Iran and has begun withdrawing the remaining troops in the Middle East. These trends are likely to continue in 2019 as President Trump focuses on China and lesser issues like Venezuela. There is one important area of alignment between him and the defense and intelligence community, notwithstanding recent scuffles: less focus on the Middle East means more focus on Asia and specifically China. However, President Trump is facing a dilemma. Despite an extraordinary economic performance, his popularity remains in the doldrums. When faced with similar situations in the past, presidents far more orthodox than Trump have sought relevance abroad, by means of military interventions. A convenient opportunity has presented itself in Venezuela, where a revolution against Chavismo could give the U.S. an opening to intervene. On paper, we see how such a scenario could look appealing for a quick, and relatively painless, intervention. The problem is that it could also get messy and, in the analysis of BCA’s Commodity & Energy Strategy, raise oil prices to nearly $100 per barrel by mid-year if a total loss of Venezuelan production ensues (Chart 18). This is a non-negligible risk. Chart 18A Venezuela Collapse Could Send Brent Crude Prices Toward $100/Bbl Bottom Line: Geopolitical risks still abound. We are not alarmist. However, there is little reason to believe that Brexit, U.S. polarization, U.S.-China tensions, or a potential U.S. intervention in Venezuela will end painlessly for the market. An unpopular U.S. president is seeking to remain relevant and a global populist wave is continuing to create unorthodox and anti-establishment policy prescriptions. Given that the current rally is supported by three shaky pillars, any one of these geopolitical risks could catalyze a relapse, the history of late-cycle rallies be damned. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Please see BCA U.S. Investment Strategy Weekly Report, “Late-Cycle Blues,” dated October 29, 2018, available at usis.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019, available at gis.bcaresearch.com. 3 Please see Reuters, “Exclusive: U.S. demands regular review of China trade reform,” dated January 18, 2019, available at reuters.com. Geopolitical Calendar
Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.
Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy. We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can. Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst. Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity. This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). South Korea Over Taiwan Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2 Yes. He literally said that. Geopolitical Calendar